Introduction to

Alternative Investments
Private Equity Returns, Fees,
Valuation and Due Diligence
1. Risk and Returns
2. Fees Structure
3. Valuation Issues
4. Due Diligence
 Private Equity

Based on historical data:

Return (%)
PE return > Traditional assets return
✦ability to invest in private companies
✦influence on portfolio companies’ operations
Private Equity ✦use of leverage

time
Traditional Corr(PE return, Traditional assets return) < 1
Investments
✦PE funds add diversification benefits to
traditional portfolios

Hypothetical data PE std dev > Traditional assets std dev

✦Higher risk in PE funds

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Private Equity

Based on historical data:

PE return > Traditional assets return

PE returns may be overstated due to
✦ability to invest in private companies survivorship and backfill bias
✦influence on portfolio companies’ operations
✦use of leverage
Portfolio companies are revalued infrequently
Corr(PE return, Traditional assets return) < 1
✦PE funds add diversification benefits to Correlations of returns →Diversification
traditional portfolios biased downwards benefits overstated

PE std dev > Traditional assets std dev

Standard deviation of →Riskier than
✦Higher risk in PE funds returns biased downwards reported

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Private Equity

Return (%) Significant I think choosing the right

differences in manager is more important
Top Quartile returns when it comes to PE funds
PE Funds
Persistence in
performance
Bottom Quartile ranking
PE Funds time

Hypothetical data

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 We need
funds for this Private Equity
investment
opportunity !

Committed
Limited Partnership Capital

Required Funds Private Equity Firm Management fee Investors amount that the LPs
General Partner 1% - 3% of Limited Partners have agreed to provide
committed capital to the PE fund

Incentive fee
Typically 20%

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Before committed capital is fully drawn down (Typically 3-5 years)
Management fee is calculated based on Committed Capital vs AUM for Hedge Funds

Private Equity

Management fee
$10M x2%= $200,000
Committed
Limited Partnership Capital
$3M
Invested
Required Funds
Funds Private Equity Firm Management fee Investors amount that the LPs
General Partner 1% - 3% of Limited Partners have agreed to provide
committed capital to the PE fund

Incentive fee
Typically 20%

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 After Before committed capital is fully drawn down
Management fee is calculated based on Committed Capital Remaining Invested Funds

Private Equity

Management fees only

applicable to
remaining investments Committed
Limited Partnership Capital
Invested Funds
Private Equity Firm Management fee Investors
1% - 3% of Returned Capital
General Partner Limited Partners
committed capital

Incentive fee
Typically 20%

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Incentive fee is based on the profits booked from the investment

Private Equity

Limited Partnership
Invested Funds

$3M Private Equity Firm Investors

Returned Capital
$1M
$800kprofits $200k
General Partner Incentive fee Limited Partners
Typically 20% GP does not earn
incentive fees until LPs
have received back
initial investment

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Clawback Provision

Private Equity

Limited Partnership
Invested Funds
Private Equity Firm Investors Returned Capital

General Partner Incentive fee Limited Partners

> 20%
$200k
Typically 20% < $800k
80%
Incentive fee Profits
possible that total incentive fees paid may exceed 20%
when all portfolio companies have been liquidated

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Clawback Provision

Private Equity

Limited Partnership
Invested Funds
Private Equity Firm Investors Returned Capital

General Partner Incentive fee Limited Partners

20%
$200k
Typically 20% 80%
$800k

Incentive fee Profits

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Use similar approaches to valuing publicly traded companies

Market/Comparables Discounted Cash Flow Asset-based

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

Public Traded
Competitor A

Competitor B
Market Portfolio
Values Multiples
Competitor C Company
x EBITDA EBITDA

Private x Net Income x Net Income = Valuation

Competitor D Recent
Sale Price x Revenue Revenue
Competitor E

Competitor F

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

Public Traded
Competitor A
Toy
Manufacturer
Competitor B
Market Portfolio
Values Multiples
Competitor C Company
x EBITDA 6.6x EBITDA $50M $330M

Private x Net Income x Net Income = Valuation

Competitor D Recent
Sale Price x Revenue Revenue
Competitor E

Competitor F

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

present value of the relevant expected future cash flows

PV = Valuation of the firm

Free cash flow to the firm (FCFF)

Future free cash flow projections

time
0 1 2 3 4 5

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

present value of the relevant expected future cash flows

PV = Valuation of the firm’s equity

Free cash flow to Equity (FCFE)

Future free cash flow projections

time
0 1 2 3 4 5

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

present value of the relevant expected future cash flows

PV = Valuation
This could be
a great
opportunity!

Asking Price

>

PE Fund Manager

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Portfolio Company Valuation
Market/Comparables Discounted Cash Flow Asset-based

Sum of all assets - Liabilities = Equity

Valuation of the
firm’s equity
Fair Value
+ +
or
Liquidation Value
+ +
< fair value
Can be realised
quickly in financial
distress or
bankruptcy

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
 Factors to Consider When Investing In Private Equity Funds

Interest Rate Outlook Long Investment Horizon Choice of GP

Similar factors to hedge
fund due diligence

High leverage
% Interest Portfolio Operating and financial
Rates Company experience
Debt long-term commitment
Valuation methods used

Availability In Exit Incentive fee structures

Equity
of capital Very
If refinancing costly!
unavailable Low Liquidity
Drawdown procedures
→Default!

Private Equity Returns, Fees, Valuation and Due Diligence

1. Risk and Returns 2. Fees Structure 3. Valuation Issues 4. Due Diligence
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